Global Infrastructure: How To Fill A $500 Billion Hole

Transcription

1 Global Infrastructure: How To Fill A $500 Billion Hole Primary Credit Analysts: Michael Wilkins, London (44) ; Steven J Dreyer, Washington D.C. (1) ; Moritz Kraemer, Frankfurt (49) ; Marco Sindaco, London (44) ; Devi Aurora, New York (1) ; Table Of Contents A Significant Increase In Institutions' Allocations Government Spending Continues To Decline In Developed Economies Governments And Banks Are Still The Biggest Players Bank Participation Evolves In Response To Regulation Drawing Institutional Investors' Interest Public-Private Partnerships Are Still Very Important Low Default Rates And High Recoveries For Infrastructure Projects Understanding The Risks And Seizing The Opportunities Related Criteria And Research JANUARY 16,

2 Global Infrastructure: How To Fill A $500 Billion Hole From the aqueducts of ancient Rome to the 47,000-mile interstate highway system in the U.S., to the breathtaking bridges, sweeping power projects, and futuristic architecture of 21st-century China, infrastructure has long been a central component of economic and human progress. Historically, funding for these projects has been the domain of governments--emperors, central planners, and legislative bodies. Although this is still the case, the public resources needed for new construction, or to repair existing infrastructure, are now under sustained downward pressure. An estimated $57 trillion will be needed to finance infrastructure development around the world through 2030, according to a report from consultant McKinsey & Co. (see chart 1). Standard & Poor's Ratings Services believes this presents institutional investors with an unprecedented opportunity to fill some of the huge gap created by public-funding shortfalls. Given the many budgetary constraints burdening governments globally, and with banks' long-term lending restricted by regulatory requirements, nontraditional lenders such as insurers and pension funds are poised take a larger share of the infrastructure investment pie. Under our base-case assumptions, we estimate that institutional investors could provide as much as $200 billion per year--or $3.2 trillion by for infrastructure financing, given recent industry-stipulated asset-allocation targets. Although this would represent an ambitious increase versus the historical trend, the gap between investment needs and available public funds could be more than twice that--at around $500 billion annually (see table 1). Chart 1 JANUARY 16,

3 Table 1 Mind The Gap: Scenarios For Global Infrastructure Investment Needs Versus Public Sector Funding Sources To 2030 Base case Downside Upside Total need through 2030 $57 trillion $57 trillion $57 trillion Government spending 3% of GDP 2% of GDP 3.5% of GDP Total gap $8.4 trillion $24.6 trillion Zero Annual gap $500 billion $1.5 trillion Zero Source: OECD; McKinsey & Co.; Global Insight. Against this backdrop, we believe that institutions could be persuaded to allocate even more of their money to infrastructure, provided certain enticements. Among these are a clearer pipeline of projects, policy incentives, less-onerous regulation, and better information about the performance expectations of the asset class in its various stages of gestation. Overview Public resources needed for new construction, or to repair existing infrastructure, are now under sustained downward pressure. About $57 trillion will be needed to finance infrastructure projects around the world through but the gap between investment needs and available public funds could be about $500 billion annually. Institutional investors' allocations to infrastructure could rise to an average of 4%, potentially providing about $200 billion per year in additional funding for the sector. If banks continue to lend to projects at current levels of about $300 billion per year, these private sector inflows could fill the gap left by retreating governments. Public policy decisions and investment incentives will play a big part in determining whether private sector institutions get more heavily involved. A Significant Increase In Institutions' Allocations Based on data provided to Standard & Poor's in advance of publication by the Organisation for Economic Cooperation and Development (OECD) and from McKinsey, we estimate the funding needs for infrastructure around the world to be $3.4 trillion annually, with most of that about evenly split among the U.S., the EU, and China. Amid this opportunity for nontraditional lenders to take on a greater share of the investment, recent developments show that some have already begun to take up the mantle. In the U.K., for example, six large insurers have said they will invest 25 billion ($40.9 billion) in the British government's National Infrastructure Plan, which plans to pump 375 billion into energy, transportation, and waste and water projects in the next five years and beyond. Institutional investors' allocations could rise to a weighted average of 4%, which could provide about $200 billion per year in additional funding for the sector. Based on figures from the OECD and infrastructure data and research firm Preqin, as well as recent statements from institutions, Standard & Poor's estimates that such investors are targeting an allocation of 3% to 8% of their assets under management over the next five years--a significant increase from what JANUARY 16,

4 we've traditionally seen (see charts 2 and 3). This could equate to as much as $3.2 trillion in new money earmarked for an asset class that is showing steady upward growth. About 40% of this would come from the pension fund sector, already one of the largest private-sector funders of infrastructure in North America and Australia. Chart 2 JANUARY 16,

5 Chart 3 As it stands, the long-term global project finance market consists of a handful of banks and various capital markets players, including insurers, infrastructure fund managers, and investors in public bonds. Of these competing businesses, institutional investors have shown the biggest increase in appetite for such investments (see table 2). A September 2013 Preqin survey showed that 58% of investors plan to increase their funding allocation for infrastructure in the long term. Almost two-thirds of respondents said they plan to allocate more capital to the sector in the next 12 months than in the previous year. Table 2 10 Largest Institutional Investors Investing In Infrastructure By Current Allocation Rank Investor Type Location Current allocation to infrastructure (bil. $) 1 OMERS Public pension fund Canada CPP Investment Board Public pension fund Canada National Pension Service Public pension fund South Korea APG - All Pensions Group Asset manager Netherlands Ontario Teachers' Pension Plan 6 Corporación Andina de Fomento (CAF) Public pension fund Canada Government agency Venezuela Current allocation (% of AUM) JANUARY 16,

6 Table 2 10 Largest Institutional Investors Investing In Infrastructure By Current Allocation (cont.) 7 AustralianSuper Superannuation scheme 8 Future Fund Sovereign wealth fund 9 Government Savings Bank of Thailand 10 CDP Capital - Private Equity Group AUM--Assets under management. Source: Preqin Infrastructure Online. Australia Australia Bank Thailand Asset manager Canada An asset-allocation survey by Mercer, the asset consultants, of Canadian pension funds shows a significant change in the percentage of pension plans investing in alternative classes from 2010 to 2013 (see chart 4). The percentage of plans invested in each of these asset classes has increased, with one of largest jumps being in infrastructure, which rose to 24% from 8% in three years. The Canadian model is often seen as one that pension funds around the world are looking to emulate. Chart 4 As these institutions prepare to increase their allocations, replacing crumbling infrastructure and the global population JANUARY 16,

7 boom are feeding the need for ever-more funds. The U.N. projects the world's population will reach 9 billion by 2050, from about 7.1 billion today. Naturally, most of that increase will come in the developing world, where the population could surge by almost one-half, to 7.8 billion. In this light, it's clear that the need for new infrastructure in the areas of energy, water, transportation, telecommunications, and social facilities such as schools and hospitals, will increase substantially. According to the U.S. Energy Information Administration, Latin America and the Caribbean will need to double power-generation capacity by 2030 to meet demand, requiring an investment of more than $700 billion. Government Spending Continues To Decline In Developed Economies All of this comes at a time when many governments--especially those in Western, developed nations--are cutting back on infrastructure spending because of budgetary concerns. In the U.S., for example, the Obama Administration's calls for increased project funding have gone unheeded as Washington lawmakers battle over the nation's budget, and government spending on infrastructure as a percentage of GDP has tumbled to a 20-year low of about 1.7%, according to figures from the Federal Reserve Bank of St. Louis. In the eurozone, the austerity measures that many governments implemented after the debt crisis have significantly constrained spending on infrastructure development and repair. In the developing economies of Asia, government allocation is much higher. In China, for example, the government has been earmarking roughly 8.5% of GDP for infrastructure (however, a large chunk of that goes for projects outside its borders), and India has been allocating roughly 4.7% of GDP. This pace of government support, however, will likely decline over the longer term relative to historical high levels. Although economic growth is forecast to rise over the next two years across much of the region, the expectation from 2017 onward is for a steady decline that may eat into planned allocations for projects that could significantly enhance those economies' competitiveness. Although the numbers vary significantly, there's been a clear trend of governments spending less of their budgets overall on infrastructure. Our base case assumes current average infrastructure investment by governments globally of about 3% of GDP (see table 1 above). With the world economy set to grow to $122 trillion by 2030, from around $70 trillion today, according to economic forecasting organization Global Insight, we calculate an annual gap of $500 billion in global infrastructure requirements that private investors have an opportunity to plug. This assumes governments continue to pledge funds at the current pace. If, however, aggregate government allocation continues to decline--to, say, 2% of global GDP--the public-funding shortfall in infrastructure investment could balloon to as much as $1.5 trillion per year. This pessimistic scenario (which we see as unlikely to occur, given current emerging-market trends) could lead to chronic shortages of infrastructure, with potential adverse economic consequences. However, if governments around the world increased spending on infrastructure to upwards of 3.5% of GDP on average, the funding requirements through 2030 could be fully met through public funding. This--our most optimistic scenario--is also the one we view as least likely. At any rate, infrastructure needs vary greatly from country to country--with a fairly clear dichotomy between more developed countries and emerging markets. In the former, where, for example, bridges and tunnels along many main thoroughfares are more than a century old and have lasted well beyond their planned lifespan, refurbishment and JANUARY 16,

8 replacement will likely take a larger slice of the financing pie than in developing nations. In the latter, new systems and networks are needed to keep pace with population--and economic--expansion. In many ways, this puts developing economies at an advantage, because technological advancements in a number of areas mean that crumbling legacy systems and structures won't be the burden they sometimes are in developed countries. India's telecommunications network is a great example of this. The number of mobile phones in that country is about 1 billion--about 30 times the number of land lines in use--and growing fast, with service providers free of the need to run cable to rural areas, where just one-third of the population now has telephone service, according to mobile provider Telecom India. Similarly, coming advancements in green energy sources hold the promise of allowing power providers in emerging markets to build state-of-the-art transmission systems--in stark contrast to the U.S., for example, where the electrical grid, while more expansive than ever, still relies on what is essentially a century-old technology. Governments And Banks Are Still The Biggest Players To be sure, healthy government participation is still paramount for the evolution of a country's infrastructure. And not all governments are scaling back in this regard. In Canada, for example, several provinces have increased capital spending in the face of deteriorating social infrastructure. Outlays for such projects as roads, schools, hospitals, courthouses, and prisons now account for about 10% of total government spending versus a historical average of 3% to 5%--with many provinces establishing private-public partnerships (PPP or P3) to fund infrastructure renewal. Clearly, banks, too, remain important providers for infrastructure financing, particularly when capital markets are thin and secondary debt markets nascent. Although their involvement varies substantially by region, banks have historically participated in the debt financing--and, to a lesser extent, equity financing--of projects. In Latin America, for example, most infrastructure financing comes through the banking sector, with larger participation of the government-owned banks in countries such as Brazil, given the relatively short track record of capital markets in the region. The lack of a strong secondary market for debt also curbs the financing of projects outside banks' balance sheets. Similarly, because debt markets are relatively new to the six-country Gulf Cooperation Council (GCC), most deals there are financed with bank credit. In addition to local lenders, certain foreign banks (particularly Japanese) are active in the market. Local banks traditionally carry the exposures on their balance sheets, rather than distributing them or selling them off. Most projects undertaken in the GCC involve highly rated government companies, are generally part of a national development strategy, and are seen as having strong credit. Meanwhile, the 8.5% of GDP that the Chinese government is spending means the country has become the world's largest investor in infrastructure, according to figures from McKinsey. On top of that, local Asian banks don't generally have the types of liquidity concerns they did in the 1990s, when they couldn't finance domestic infrastructure, and project bonds funded a range of power projects. Against this backdrop, nontraditional lenders aren't making the same inroads into infrastructure financing in Asia as JANUARY 16,

9 they are in the U.S. and Europe, because of the dominance of Asian banks, which can provide financing cheap enough to price out competitors. In addition, Asian banks' desire to expand their balance sheets--in contrast to the U.S. and EU banks--means they are highly motivated to keep foreign and nontraditional lenders out. At least for the time being, debt financing of Asian infrastructure is the preserve of the Asian banks. Despite this, a large number of institutional investors are seeking greater exposure to Asian infrastructure. And investing in such projects seems to be a good match, in particular for insurers and pension funds, because of the predictable, stable cash flows and potential for asset-liability matching. Still, the comparatively low credit quality of sovereign borrowers and issuers in the region, combined with currency-fluctuation risks and too-low yields, may hold many investors back. Bank Participation Evolves In Response To Regulation All of this is taking place as the nature of bank involvement in project finance is evolving in response to changing regulation. In Europe, we've seen a pullback from infrastructure loans as governments deal with strained budgets in the wake of the recent financial crisis. Meanwhile, new capital and liquidity rules under Basel III suggest that banks will have a diminished appetite for relatively illiquid assets such as project finance. New rules will require lenders to seek longer-term funding, which is generally more expensive, to better match their assets with their liabilities. Simply put, while the negative effects of the deleveraging that banks undertook to prepare for new regulations (and a gloomy economic backdrop) are waning a bit, lenders will be more selective, and the availability of credit less abundant, than in the past--and with more demanding capital and funding requirements. In light of this, banks are diversifying away from buy-and-hold strategies in favor of roles as arrangers of deals. In Latin America, Basel III requirements could somewhat reduce banks' appetite for financing longer-term investments or holding lower-rated assets, but Standard & Poor's believes the deep need for infrastructure funding in the region will overcome these obstacles. This could be done through the continuing participation of government-owned development banks, as long as their funding and capital structures aren't limited by governments' budgetary constraints, or via further capital-markets development. Similarly, in the GCC, we see the implementation of Basel III curbing local banks' appetite for such exposures, and we expect project bond issuance, which has been limited to date, to gradually increase. And while there isn't yet any evidence of a decline in project finance exposures in Asia-Pacific, the pace of growth may slow in the next decade due to Basel III constraints. All told, deepening capital markets and the greater participation of nonbank investors can help expand private financing opportunities for infrastructure, with banks still likely to step in as arrangers and facilitators, or to provide bridge financing. Certainly, institutional investors can play a larger role, and there is scope for them to increase their allocations to infrastructure from the current low levels. This will likely foster growth in capital markets assets, specifically project bonds. JANUARY 16,

10 This trend has already started. According to the latest data from Dealogic, global project finance bond volume reached $54.7 billion in 2013, more than double the $25.5 billion raised in 2012 and the highest full year volume on record. Global project finance volumes overall increased 3% in 2013 to $418 billion. In the same period, project finance loan volume dropped 4%, to $297 billion. Financing can take a number of routes. We see European banks potentially providing bridge financing during a project's construction phase, with refinancing coming from a bond sale or investment from the infrastructure funds, insurers, or pension managers that need long-term yields. Alternatively, the bond market might provide all of the required financing from the outset, which has been the U.S. model for many years. However, because Europe's traditional way of debt financing--bank lending--will need to keep working in a big way, it's important to be realistic about the potential role of institutional investors. We believe significant increases in institutional involvement are possible only with sufficient supply of infrastructure assets and favorable political-economic environments. In Latin America, meanwhile, the need for infrastructure spending could create an opportunity for further development of the capital markets. In most of the region's countries, regulations have fostered an infrastructure project bond market, including allowing pension funds and other institutional investors to participate. In Asia-Pacific, by contrast, project finance bonds remain unpopular and have a very limited presence, compared with loans. Nevertheless, given the aforementioned large financing gap, we expect non-loan instruments such as project financing bonds to become more prominent there. Drawing Institutional Investors' Interest Institutional investors are becoming increasingly attracted to infrastructure, due to their need to match long-term assets and liabilities--while at the same time picking up higher yields than they might get from traditional investments in investment-grade sovereign and corporate debt. Still, many nontraditional investors remain wary of such assets. Key to increasing their participation, perhaps, is a better understanding of the risks associated with this type of lending. Toward this end, the World Bank plans to funnel capital from member nations and the private sector into projects in developing countries through a new Global Infrastructure Facility--an intermediary that World Bank President Jim Yong Kim believes will help match lenders and borrowers, and mitigate risk. Meanwhile, Justin Lin, former chief economist at the World Bank, and Kevin Lu, director of the World Bank Group's Multilateral Investment Guarantee Agency for the Asia-Pacific region, have called for the creation of a fund that would help nontraditional, private-sector lenders become more comfortable with infrastructure investment. In an October 2013 editorial on the Huffington Post, the two pointed out that infrastructure investment requires a deeper level of expertise than that needed to invest in most existing asset classes. As such, "most long-term capital holders such as pension funds are unlikely to have the expertise already in place." The ability for such lenders to look at infrastructure as a discrete asset class, with clearly defined risks and rewards, could make them more comfortable with such investments. The increased target allocation of AUM by institutions to infrastructure is a sign that this may already be happening. Although project finance offers some attractive characteristics for these lenders, Standard & Poor's believes there are a number of elements to be put in place before a market for project bonds can thrive at scale--not the least of which is JANUARY 16,

11 some standardization of deal structures. (See "How To Unlock Long-Term Investment In EMEA Infrastructure," published Oct. 4, 2013.) In Europe, for example, investor appetite for infrastructure assets is strong, but there has been only limited issuance of project finance capital market debt in the past five years. Most infrastructure funding requirements are still being met by bank lending. Still, we believe long-dated debt used to fund infrastructure will more likely be from alternative or nonbank sources in the next 12 months, in light of certain advantages that providing such long-term capital can offer. Among the benefits are: Yields higher than those on government bonds and similarly rated corporate bonds (primarily because of an "illiquidity premium" on project debt and that infrastructure bonds typically are not backed by the full faith and credit of the government sponsor); The ability to match long-dated assets and liabilities; Comparatively low default totals, and higher recovery rates, than we see among corporate bonds; and The chance to diversify into a broader investment pool, with low correlation to other asset classes. That said, it's important to heed the factors that may hinder the participation of certain institutions. In Europe, for example, there is some concern that risk capital charges proposed for insurance companies under Solvency II, scheduled to take effect in 2016, will discourage insurers from providing long-term financing. Because the regulation was conceived with a focus on corporate loans--and doesn't account for specific default and recovery characteristics of project finance, or other factors such as strong security packages and transaction structures--the proposal could effectively penalize insurers for holding long-dated, low- to-mid-investment-grade project debt (that is, debt in the 'BBB' and 'A' categories). Regarding our analysis of infrastructure investment, we don't necessarily factor in specific risk-based capital charges, although this would depend on our view of the risks. Our approach would look at the investor's position in the capital structure, the nature of the underlying assets, leverage levels, and risks regarding liquidity, valuation, and timing. Meanwhile, many insurers and pension funds remain reluctant to directly invest in projects before completion (so-called "greenfield" projects). This is partly because of the possibility of delayed yields and the potential effects that loan prepayments have on long-term returns--but is perhaps more directly a reflection of their wariness of taking on construction risk. In our view, however, construction risk is seldom the main reason for a project to default. In the power sector, for example, defaults are more likely to occur as a result of technical and design failures, poor operational performance, or unexpected capital expenditures. Another factor that could dissuade investors, particularly in countries with less-established track records in PPPs, is political and regulatory risk. Government and regulatory interference and political risk are by far the biggest concerns on investors' minds, with almost 60% of respondents to a survey by London-based law firm Berwin Leighton Paisner, undertaken in conjunction with Preqin, citing this as the main threat to a sustained flow of infrastructure transactions in the next 12 months. The support of independent, stable, and transparent regulatory frameworks, or frameworks enshrined in law, reduce the risk of adverse policy changes on a transaction. Such changes can discourage investor participation and in certain cases have the unintended effect of increasing a project's default risk. JANUARY 16,

12 When Standard & Poor's assesses a regulatory framework, we consider, among other things: Its stability and predictability; How operating and capital expenditures are recovered; How financial stability is supported; and To what extent the framework is insulated from political intervention. At the same time, because project finance loans are rarely traded in the secondary market, they often don't meet the liquidity requirements that institutional investors demand--a drawback that can't always be counterbalanced with an illiquidity premium of even 50 to 100 basis points. Still, investors interested in holding such assets to maturity would benefit from this substantial difference in yield. In Asia, the key to attracting private financing is a steady flow of investable projects. For this to occur, in our view, a reliable and predictable revenue stream, creditworthy counterparties that deliver cash flow, and a reliable legal system to protect investors are essential. Public-Private Partnerships Are Still Very Important As markets and governments develop new approaches to completing highly essential infrastructure projects, Standard & Poor's believes that initiatives such as the Canadian government's C$1.25 billion five-year contribution to the Canadian P3 Fund and the U.K.'s Private Finance 2 will continue to draw financing using public-private partnerships. In the U.S., interest is growing as several states build robust PPP programs. California, Florida, Indiana, Texas, and Virginia are among those that have initiated PPPs. Advantages to this model are that it includes some level of private investment and that there is, typically, a transfer of construction and operating risk to the private party. Similarly, we believe the infrastructure needs of most Latin American countries will continue to drive long-term investment in PPPs. Nevertheless, the use of PPPs to channel investments across the region is still marginal and uneven, with Chile and Mexico taking the lead. We expect countries such as Uruguay and Peru to start using this type of mechanism more actively in 2014 though, for the region as a whole, we expect PPPs to remain a relatively minor source of project funding. In Europe, we expect the trend of increased issuance in the social and economic infrastructure sectors to continue. Especially strong last year were the higher-education and social-housing sectors, in terms of number of deals, with larger volumes in the power generation, transmission, and gas-storage sectors. For 2014, we expect all of these areas to continue growing, with strong emphasis on infrastructure network transactions--such as energy, transportation, and communications--given that these are priority areas for the EU's and European Investment Bank's project bond initiative. It's clear that the market for funding long-term investments is in transition, globally. According to the latest Dealogic data, project bonds already accounted for 13% of total project finance raised in 2013 and 16% of total project finance debt. Although commercial banks will retain a significant market share, we believe long-dated debt that finds its way into infrastructure is more likely to come from alternative or nonbank sources. JANUARY 16,

13 Naturally, yields and prices that are attractive to both lenders and borrowers are crucial to the market's success. For now, historically low yields on long-term government debt, as well as tight credit spreads throughout the capital markets, make for pricing on project bonds that favors borrowers. Low Default Rates And High Recoveries For Infrastructure Projects Standard & Poor's default and recovery statistics indicate that the creditworthiness of infrastructure projects is strong, and we expect this to continue. Since the first rated project default in 1998, the average annual default rate for all project finance debt we rate is just 1.5%--below the 1.8% default rate for corporate issuers in the same period. Simply put, projects are generally no more risky than corporate entities at comparable rating levels. Although defaults among corporate borrowers increased at the height of the global financial crisis in , project finance transactions remained resilient. In 2007, the annual default rate for global rated project finance deals was about 0.5%. In 2009, it was 0.75%. Various contractual protections, such as those that provide projects with stable revenues, contributed to this comparatively low rate of default (which, we should note, comes from a significantly smaller set of rated transactions--around 200--than the more than 4,000 corporate issues we rate). On top of its stronger resistance to default, project finance debt also delivers a better rate of recovery when defaults do happen. The average recovery rate across Standard & Poor's rated project finance portfolio is about 75%--with most lenders receiving close to 100%, and very few getting shut out entirely. This reflects the specific characteristics of project debt, which typically benefits from strong collateral, with lenders enjoying first-priority security. In many cases, strong collateral in tandem with certain contractual features enables projects that default to continue as going concerns, thereby ensuring cash flow and bolstering recovery prospects. Unrated project loans, too, typically afford full recovery, which we define as 91% to 100%, according to data collected by S&P Capital IQ. Either way, it's clear that post-default recoveries for project finance are considerably stronger than the average of about 45% among corporate borrowers. Understanding The Risks And Seizing The Opportunities All told, institutional investors look set to capitalize on what Standard & Poor's sees as an unprecedented opportunity to invest in infrastructure around the world. A steady flow of projects and a better grasp of the risks associated with infrastructure lending are helping to draw pension funds, insurers, and other nontraditional financiers to investments that boast higher yields, as well as comparatively low default rates and better recoveries, than those similarly rated corporate debt, while also offering the asset-liability management that these investors need. While only time will tell whether institutions' financing of projects reaches critical mass and completely offsets public-funding shortfalls, all signs point to investors' increased allocations potentially filling a significant portion of the hole that governments leave, with other traditional sources of capital being called upon to provide the rest. Writer: Joe Maguire JANUARY 16,

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